ECB lowers collateral standards signaling that stress is still rising in European banking sector

06/22/2012 5:37 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Watch what they do and not what they say, if you want to track the trend in the euro debt crisis.

This morning’s headlines from Rome, where the leaders of Germany, France, Italy, and Spain have just completed a mini-summit in advance of next week’s full European summit, are full of calls to action.

“There was an agreement between all of us to use any necessary mechanism to obtain financial stability in the EuroZone,” Spanish Prime Minister Mariano Rajoy said in the post-meeting press conference.

“I absolutely agree with what everyone else here has said--to devote 1% of the GDP of the European area additionally to growth, to efficiency in growth and to investment. That is a genuine signal that we need,” said Germany Chancellor Angela Merkel. (That 1% of GDP amounts to about 130 billion euros ($164 billion.)

Sounds like we might be on an upward track, right?

Well, in the world of actions and not words, today, the European Central Bank agreed to accept lower-rated asset-backed securities as collateral for loans to European banks. Asset-backed securities, including those backed by commercial mortgages, auto loans, and consumer finance loans, will now be eligible as collateral as long as they are rated at least BBB. In the Standard & Poor’s credit ratings system BBB is one grade above BBB-, the lowest investment grade rating, and just two grades above a speculative rating of BB+. The central bank will apply a haircut to these lower-rated credits so, for example, $100 in BBB-rated asset-backed securities could serve as collateral for just $84 in bank borrowing. But make no mistake about it, today’s action is a major expansion of the kinds of collateral that the central bank will accept.

Why is this important?

The European Central Bank wouldn’t be expanding the list of collateral that it accepts from banks if some banks weren’t having trouble finding funding for their operations. My read is that some banks, even after the central bank’s huge provision of cash through its December and February 3-year loan facility, are having trouble funding their operations because they don’t have enough collateral under the former rules to use to secure central bank loans. Easing the standards for collateral addresses this problem—and is a sign of exactly how stressed some banks in Europe are. (Once upon a time, when Jimmy Stewart ran the Bailey Building and Loan, banks raised the money they lent out from depositors. Nowadays, some funding for loans still comes from depositors, but until this crisis it increasingly came from the short-term capital markets where banks borrow the money they lend. These markets have been closed to many banks by the global financial crisis and the euro debt crisis. And that has left banks scrambling for new sources of funding—and for new funding sources that will let them roll over their short-term money as it comes due. It has also led some banks to rediscover the value of deposits from savers.)

A source of that stress is the continued reluctance of U.S. money market funds to provide short-term funding for European banks. According to data from Fitch Ratings money market funds are allocating about 12% of their assets to EuroZone banks in 2012. That’s down from roughly twice that allocation a year ago. Before the crisis, many European (and other) banks had come to rely on cash from money market funds to fund their operations. That money is now in short supply and although EuroZone banks have all said that they have moved away from this source of funding, it’s a good bet that not all of them have made the shift.

Hence the need for the European Central Bank’s move on collateral today.

It’s hard to tell exactly where the most stress is in the EuroZone banking system. But I’d look to France where the banks were especially dependent on short-term funding from the capital markets. And I’d look to smaller banks certainly in Italy and Spain, but also in Germany. It is interesting—maybe “revealing” is a better word—that Germany is all in favor of more regulation by a central banking authority as long as that regulation covers only the country’s biggest banks. Germany starts to balk, however, when the proposal starts to include centralized EuroZone regulation of the country’s smaller banks.

Related Articles on STOCKS